UNIT IV FUND BASED FINANCIAL SERVICES

Leasing and Hire Purchasing – Basics of Leasing and

Hire purchasing – Financial Evaluation
Basics of Leasing
Definition
Leasing is a contractual agreement in which one party (the lessee) obtains the right to use an asset owned by another party (the lessor) for a
specified period in exchange for periodic payments. Leasing is widely used by businesses and individuals to access expensive assets like
machinery, vehicles, and real estate without the need for an outright purchase.

Parties Involved in Leasing:

● Lessor: The owner of the asset who grants the right to use the asset to the lessee. The lessor retains ownership of the asset
throughout the lease term.
● Lessee: The party that acquires the right to use the asset from the lessor for a specified period. The lessee makes regular payments
to the lessor as agreed in the lease contract.

Types of Leasing:
1. Operating Lease:
Definition:

An operating lease is a short-term lease where the lessor retains the risks and rewards of ownership. The lease term is
typically shorter than the useful life of the asset.
Characteristics:

● The lessee does not have the option to purchase the asset at the end of the lease.
● Maintenance and insurance are often handled by the lessor.
● Lease payments are usually lower compared to finance leases.
● The asset is not recorded on the lessee’s balance sheet (off-balance-sheet financing).

Examples: Leasing of office equipment, vehicles, or computers.

2. Finance Lease (Capital Lease):

● Definition: A finance lease is a long-term lease where the lessee effectively takes on most of the risks and rewards of
ownership. The lease term often covers the majority of the asset's useful life.
● Characteristics:
○ The lessee may have the option to purchase the asset at the end of the lease term, often for a nominal amount.
○ The lessee is responsible for maintenance, insurance, and other operating costs.
○ The asset is recorded on the lessee’s balance sheet as an asset and liability.
○ Lease payments are generally higher than those of an operating lease.
● Examples: Leasing of industrial machinery, commercial aircraft, or real estate.
Key Components of a Lease Agreement
Lease Term: The period during which the lessee has the right to use the leased asset. The lease term can range from a few months to
several years, depending on the type of lease and the asset involved.

Lease Payments: The periodic payments made by the lessee to the lessor for the use of the asset. These payments are typically made on
a monthly, quarterly, or annual basis and can be fixed or variable.

Residual Value: The estimated value of the leased asset at the end of the lease term. In a finance lease, the lessee might have the option
to purchase the asset for its residual value.

Maintenance and Operating Costs: Depending on the lease type, either the lessor or the lessee may be responsible for maintenance,
insurance, and other operating costs. In an operating lease, the lessor often handles these, while in a finance lease, the lessee usually
bears these costs.

Purchase Option: Some lease agreements, particularly finance leases, include a purchase option that allows the lessee to buy the asset
at the end of the lease term, typically at its residual value or a pre-agreed amount.

Termination Clause: This clause specifies the conditions under which the lease can be terminated before the end of the lease term,
including any penalties or fees for early termination.
Advantages and Disadvantages of Leasing:

Advantages:

● Lower Initial Costs: Leasing often requires a lower initial outlay compared to purchasing, preserving capital for other
investments.
● Flexibility: Leasing agreements can be tailored to suit the needs of the lessee, including the option to upgrade or
switch assets.
● Tax Benefits: Lease payments can be tax-deductible, providing a financial advantage.
● Maintenance and Upgrades: In operating leases, maintenance and the ability to upgrade to newer models are often
included.

Disadvantages:

● Higher Long-Term Cost: Over the entire lease term, leasing can sometimes be more expensive than purchasing the
asset outright.
● No Ownership: In most leases, the lessee does not gain ownership of the asset unless they exercise a purchase option,
which can be limiting.
● Commitment: Lease agreements can lock the lessee into payments for the lease term, even if the asset is no longer
needed or becomes obsolete.
Common Applications of Leasing:
● Real Estate Leasing: Commercial and residential properties are often leased rather than purchased,
especially in prime locations where property prices are high.
● Vehicle Leasing: Leasing of cars, trucks, and fleets is popular among businesses and individuals who prefer
not to own depreciating assets.
● Equipment Leasing: Businesses lease machinery, computers, and other equipment to avoid the high upfront
costs and to stay current with technological advancements.

Lease Accounting Standards:

● IFRS 16 / ASC 842: These accounting standards require companies to recognize most leases on their balance
sheets, leading to greater transparency but also impacting financial ratios like debt-to-equity and return on
assets.
Basics of Hire Purchasing

Hire Purchase (HP) is a type of financial arrangement where a buyer acquires an asset by making an initial down payment,
followed by a series of regular installment payments. The ownership of the asset is transferred to the buyer only after all the
installments, including interest and fees, have been paid in full. Hire purchase is commonly used for the acquisition of high-
value items such as vehicles, machinery, and consumer goods.

Key Concepts in Hire Purchasing:

1. Buyer (Hirer):
○ The party who wants to acquire the asset and agrees to pay the installments over a specified period. The buyer
has the right to use the asset during the hire purchase term but does not own it until the final payment is made.
2. Seller (Owner):
○ The party selling the asset under the hire purchase agreement. The seller retains ownership of the asset until all
payments are completed.

3. Finance Company:

● Often, a finance company or bank acts as an intermediary, purchasing the asset from the seller and leasing it to the
buyer under the hire purchase terms. The buyer makes payments to the finance company rather than directly to the
seller.
Structure of a Hire Purchase Agreement:
1. Down Payment:
○ The buyer makes an initial payment, usually a percentage of the total asset value. This down payment reduces the total amount to
be financed.
2. Installments:
○ The remaining cost of the asset, along with interest and fees, is divided into equal payments (installments) over a fixed period.
These installments are usually paid monthly, but other frequencies (e.g., quarterly) are possible.
3. Interest Rate:
○ The hire purchase agreement includes an interest rate, which can be fixed or variable. This rate determines the total cost of the
financing over the term of the agreement.
4. Duration of the Agreement:
○ The hire purchase term is the period over which the buyer makes payments. This period can range from a few months to several
years, depending on the agreement.
5. Ownership Transfer:
○ The ownership of the asset is transferred to the buyer only after all installment payments, including interest and any additional
charges, have been made. Until that point, the asset legally belongs to the seller or finance company.

6. Option to Purchase:

● Some hire purchase agreements include an “option to purchase” fee, which is a nominal fee the buyer pays at the end of the agreement to transfer
ownership formally.
Key Features of Hire Purchasing:

1. Ownership:
○ Unlike a lease, where ownership typically remains with the lessor, hire purchase allows for the transfer of
ownership to the buyer once all payments are completed. The buyer gains legal ownership after the final
installment is paid.
2. Usage of the Asset:
○ The buyer can use the asset as if it were their own during the hire purchase period. However, they cannot sell or
transfer the asset to another party until ownership is fully transferred.
3. Security:
○ The asset itself often serves as security for the hire purchase agreement. If the buyer fails to make the required
payments, the seller or finance company can repossess the asset.
4. Depreciation:
○ The buyer may be responsible for accounting for depreciation of the asset, depending on the jurisdiction and
accounting standards. This depreciation reflects the reduction in the asset’s value over time.
5. Default and Repossession:
○ If the buyer defaults on payments, the seller or finance company has the right to repossess the asset. This means
the buyer loses both the asset and any payments already made.
Advantages:

● No Large Upfront Payment: The buyer can acquire and use the asset without paying the full purchase price upfront.
● Ownership: The buyer eventually gains ownership of the asset, which can be important for businesses and individuals who
prefer owning assets rather than leasing them.
● Fixed Payments: Installments are usually fixed, making it easier for the buyer to budget and manage cash flow.
● Flexibility: Hire purchase agreements can be tailored to the buyer's financial situation, with terms that can vary in length and
payment structure.

Disadvantages:

● Higher Overall Cost: The total cost of the asset may be higher than purchasing it outright due to interest and fees associated
with the hire purchase agreement.
● Obligation to Pay: The buyer is committed to making regular payments throughout the hire purchase period, which can strain
finances if cash flow issues arise.
● Risk of Repossession: If the buyer fails to meet the payment obligations, the asset can be repossessed, leading to the loss of both
the asset and the payments already made.
● Depreciation: The buyer bears the risk of depreciation, meaning the asset may lose value faster than the payments are made,
especially with rapidly depreciating assets like vehicles.
Common Applications of Hire Purchasing:
● Vehicle Acquisition: Hire purchase is commonly used by individuals and businesses to finance the purchase of cars,
trucks, and other vehicles. It allows the buyer to use the vehicle immediately while spreading the cost over time.
● Industrial Equipment: Businesses often use hire purchase agreements to acquire expensive machinery and
equipment, enabling them to increase production capacity without a large upfront capital outlay.
● Consumer Goods: Some hire purchase agreements are used for acquiring high-value consumer goods such as
electronics, furniture, and home appliances.

Legal and Regulatory Considerations:

● Consumer Protection Laws: Many jurisdictions have specific laws governing hire purchase agreements to protect
consumers, ensuring they are fully informed about the terms, interest rates, and total costs involved.
● Disclosure Requirements: The terms of the hire purchase agreement, including the total cost, interest rates, and
payment schedule, must be clearly disclosed to the buyer before the agreement is signed.
● Rights and Obligations: Both the buyer and seller have rights and obligations under the hire purchase agreement. The
seller must deliver the asset in good condition, while the buyer must make payments as agreed.
Financial Evaluation for Leasing
Financial evaluation of leasing is a critical process to determine whether leasing an asset is more beneficial than purchasing it outright or
through financing. This evaluation involves analyzing various financial metrics, understanding the tax implications, and assessing the
impact on the company’s financial statements.

1. Lease vs. Buy Analysis

A Lease vs. Buy Analysis compares the costs and benefits of leasing an asset versus purchasing it. The analysis considers the following
factors:

● Initial Outlay: Leasing typically requires a lower initial outlay compared to purchasing, where the full cost or a significant
down payment is required upfront.
● Total Cost Over Time: Evaluate the total lease payments over the lease term versus the total cost of purchasing, including
financing costs, maintenance, and potential depreciation.
● Net Present Value (NPV): Calculate the NPV of leasing versus buying to determine the better option financially. NPV accounts
for the time value of money, discounting future lease payments or loan repayments to present value terms.

Example NPV Calculation: NPV=∑Ct(1+r)t\text{NPV} = \sum \frac{C_t}{(1 + r)^t}NPV=∑(1+r)tCt​​Where:

● CtC_tCt​= Cash flow at time ttt

● rrr = Discount rate
● ttt = Time period
2. Cash Flow Impact

Leasing can have a significant impact on cash flow:

● Lower Initial Payment: Leasing usually requires less cash upfront, preserving cash flow for other business needs or investments.
● Predictable Payments: Lease payments are often fixed and spread evenly over the lease term, making budgeting easier.
● Operating Leverage: Leasing can improve operating leverage by reducing capital expenditures, which can enhance return on assets (ROA) and free
up cash for other uses.

3. Tax Implications

Leasing has specific tax benefits, which vary depending on the lease type and local tax laws:

● Tax Deductibility: Lease payments are often fully deductible as an operating expense, reducing taxable income.
● Depreciation: In the case of a finance lease, the lessee may claim depreciation on the leased asset, providing an additional tax benefit.

4. Impact on Financial Statements

The accounting treatment of leases can affect a company’s financial statements:

● Balance Sheet: With finance leases, the leased asset and corresponding liability appear on the balance sheet, which impacts financial ratios such as
the debt-to-equity ratio.
● Income Statement: Lease payments for operating leases are recorded as operating expenses, affecting net income. For finance leases, interest and
depreciation are recorded separately.
● Cash Flow Statement: Lease payments affect the cash flow from operations in operating leases and cash flow from financing activities in finance
leases.
5. Residual Value Consideration
In some leases, particularly finance leases, there may be a residual value at the end of the lease term:
● Purchase Option: The lessee may have the option to purchase the asset at a pre-determined residual value.
This needs to be factored into the financial evaluation.
● Asset Return: If the asset is returned, there may be costs associated with wear and tear, or other end-of-lease
obligations.
6. Risk Management
Leasing can help manage certain financial and operational risks:
● Obsolescence Risk: Leasing mitigates the risk of asset obsolescence, especially for rapidly changing
technologies or equipment.
● Maintenance and Repairs: In operating leases, the lessor often covers maintenance costs, reducing the
lessee’s operational risks.
Financial Evaluation of Hire Purchasing:

1. Total Cost of Ownership:

○ The total cost includes the down payment, the sum of all installment payments, and any interest charges. This total should
be compared with the cost of purchasing the asset outright or through other financing methods.
2. Effective Interest Rate:
○ The effective interest rate on the hire purchase agreement should be evaluated. It represents the true cost of financing and
should be compared with alternative borrowing options.
3. Cash Flow Management:
○ Hire purchase allows for spreading the cost of an asset over time, which can help with cash flow management. This can
be particularly beneficial for businesses that need to acquire expensive assets without disrupting their working capital.
4. Tax Implications:
○ In many jurisdictions, the interest portion of the hire purchase payments may be tax-deductible. Additionally, the buyer
may be able to claim depreciation on the asset, depending on the local tax laws.
5. Impact on Balance Sheet:
○ Under hire purchase, the asset is typically recognized on the buyer’s balance sheet, along with a corresponding liability
for the remaining payments. This can impact financial ratios, such as the debt-to-equity ratio and return on assets.